The US Securities and Exchange Commission (Commission) adopted amendments to the rule governing money market funds on July 12, 2023 in an attempt to address concerns about institutional prime and institutional tax-exempt (i.e., municipal) money market funds, which experienced large outflows during the COVID-related market turbulence in March 2020 that contributed to stress on short-term funding markets.
In a departure from the proposed amendments (Proposed Rule), [2] the Commission did not adopt a controversial provision that would have required institutional prime and institutional tax-exempt money market funds to implement swing pricing during periods of net redemptions (under swing pricing, a fund would be required to adjust its current NAV by a swing factor reflecting spread costs, transaction costs, and under certain circumstances, market impact costs). Industry participants widely opposed a swing pricing requirement as unnecessary, expensive, and difficult to implement. In the Final Rule, the Commission replaced swing pricing with a mandatory liquidity fee framework that incorporates certain elements of the swing pricing proposal—and may, much like swing pricing, raise implementation challenges for funds.
Increased Minimum Daily and Weekly Liquidity Requirements
As in the Proposed Rule, the Final Rule increases minimum daily and weekly liquidity requirements. Currently, money market funds other than tax-exempt money market funds must hold at least 10% of their total assets in “daily liquid assets” and 30% in “weekly liquid assets.” [3] Under the Final Rule, money market funds are required to hold at least 25% of their total assets in daily liquid assets and at least 50% of their total assets in weekly liquid assets. Tax-exempt money market funds continue to be exempt from the daily liquid asset minimum requirement.
Additionally, the Commission adopted a new board reporting requirement for money market funds that fall below certain liquidity thresholds. Under the Final Rule, a money market fund that holds daily liquid assets equal to less than 12.5% of its total assets or weekly liquid assets equal to less than 25% of its total assets will be required to notify its board within one business day of the shortfall and provide the board with a description of the circumstances leading to the shortfall within four business days of the event.
The Commission noted that the revised daily and weekly liquidity minimums are designed to create a more substantial buffer against rapid redemptions during times of extreme market stress. The Commission believes that, based on its analysis of money market fund outflows during March 2020, the minimum liquidity thresholds adopted in the Final Rule will be sufficient to allow money market funds to effectively manage their liquidity risk during a market crisis.
The increased minimum liquidity requirements will impact portfolio construction for institutional and retail prime funds and are likely to negatively impact such funds’ yields.
Removal of Temporary Redemption Gates
In 2014, the Commission adopted rule amendments that permit the board of a nongovernment money market fund to temporarily suspend (or “gate”) redemptions for up to 10 business days within a 90-day period if the fund’s weekly assets fall below 30% of its total assets. The redemption gate provision was intended as a tool for funds to preserve liquidity by creating a “cooling off” period during times of extreme market volatility. Despite the intention of the 2014 reforms, analysis of the March 2020 volatility showed that the threat of liquidity gates exacerbated redemption pressure on money market funds as investors rushed to exit positions before a gate could be imposed.
The Final Rule removes the ability of a money market fund to impose a redemption gate. The Commission believes that, among other things, the removal of the redemption gate provision may mitigate the first mover advantage that had previously incentivized investors to exit their positions before a redemption gate could be imposed.
Mandatory Liquidity Fee Framework
Currently, the board of a nongovernment money market fund is permitted to impose a liquidity fee of up to 2% if the money market fund’s weekly liquid assets fall below 30% of its total assets, and the board is required to impose a 1% liquidity fee on all redemptions if the fund’s weekly liquid assets fall below 10% of its total assets, unless the board determines that imposing such a fee would not be in the best interest of the fund.
The Final Rule removes the regulatory tie between the imposition of liquidity fees and a fund’s liquidity level. Under the Final Rule, institutional prime and institutional tax-exempt money market funds, including those that are not publicly offered, must impose mandatory liquidity fees when a fund experiences net redemptions that exceed 5% of net assets, unless the fund’s liquidity costs are de minimis (i.e., less than 1 basis point). Retail money market funds and government money market funds would not be subject to this requirement.
The Commission adopted the new liquidity framework in lieu of a requirement to implement swing pricing for any period of net redemptions. As noted above, the swing pricing proposal was widely opposed by the industry. The Commission stated that it was influenced by commenters who suggested that a modified liquidity fee structure would serve as a better antidilution mechanism than swing pricing, and also acknowledged some commenters’ views that a liquidity fee framework would be easier to implement from an operational perspective and would be less confusing and more transparent to investors.
In adopting the new liquidity fee framework, the Commission hopes to achieve many of the same objectives that it sought to achieve through swing pricing; namely, to protect remaining shareholders from dilution and to more fairly allocate costs so that redeeming shareholders will bear the costs of redeeming from the fund when liquidity in underlying short-term funding markets is costly.
Accordingly, the Final Rule requires institutional prime and tax-exempt funds, in determining the amount of the mandatory liquidity fee, to make a good-faith estimate, supported by data, of the costs the fund would incur if it sold a pro rata amount of each security in its portfolio to satisfy the amount of net redemptions, including spread costs and market impacts associated with security sales. If a fund cannot make a good-faith estimate of such liquidity costs, it must apply a default fee of 1% of the value of shares redeemed. The Commission generally anticipates that a fund’s liquidity costs will be de minimis under normal market conditions.
Under the Final Rule, the fund’s board is responsible for administering mandatory liquidity fees but, consistent with other provisions of Rule 2a-7, the board is permitted to delegate this responsibility to the fund’s investment adviser or officers, subject to written guidelines established and reviewed by the board and ongoing board oversight.
Under the Final Rule, institutional prime and institutional tax-exempt money market funds are required to be able to impose mandatory liquidity fees one year from the effective date of the rule, so funds and their sponsors will not have much time to address these requirements.
Discretionary Liquidity Fee Provisions
Separately, the Final Rule retains discretionary liquidity fee provisions for nongovernment money market funds, including those that are not publicly offered, but without the tie between liquidity fees and weekly liquid assets.
Under the Final Rule, nongovernment money market funds are required to impose a discretionary liquidity fee (not to exceed 2% of the value of the shares redeemed) if the fund’s board (or its delegate) determines that a fee is in the best interest of the fund, irrespective of liquidity or redemption levels. The amendments do not prescribe the manner or amount of the fee calculation, and once imposed, the fee must be applied to all shares redeemed and remain in effect until the fund’s board determines that such a fee is no longer in the fund’s best interest.
Amendments Related to Potential Negative Interest Rates
In the Proposed Rule, the Commission expressed concerns about the operation of government money market funds and retail money market funds that seek to maintain a stable share price in negative interest rate environments. According to the proposing release, if negative interest rates turn a stable NAV money market fund’s gross yield negative and the fund’s board reasonably believes that the stable share price does not fairly reflect the fund’s market-based share price, the fund would be required to convert to a floating share price.
Under the Final Rule, government and retail money market funds may seek to maintain a stable share price by using amortized cost and/or penny-rounding accounting methods, but that approach is only permitted if the fund’s board believes that the stable share price fairly reflects the fund’s market-based NAV. The Final Rule permits a stable NAV fund to convert to a floating NAV in the event of negative interest rates; however, it does not require a fund to determine that its financial intermediaries are able to process transactions at a floating NAV as the Proposed Rule would have required.
In addition, the Proposed Rule would have prohibited a money market fund from reducing the number of its shares outstanding to maintain a stable NAV per share or stable price per share. Under the Final Rule, a stable NAV fund is permitted to reduce the number of its shares outstanding to maintain a stable NAV per share in the event of negative interest rates, subject to certain board determinations and disclosures to investors, in addition to the fund being permitted to convert to a floating NAV. [4] Investors in a fund that uses such a share cancellation mechanism would experience a stable share price but a declining number of shares for their investment, and thus an overall reduction in their account values.
Additional Changes
In addition to the amendments outlined above, the Final Rule
The Final Rule will become effective 60 days from its forthcoming publication in the Federal Register, and the Commission has adopted an aggressive compliance timeline following effectiveness of the Final Rule.
Money market funds will no longer be permitted to impose redemption gates immediately upon the effective date of the Final Rule. Further, six months from the effective date of the Final Rule, money market funds will be required to comply with the increased daily and weekly liquid asset minimums. Finally, funds will be required to comply with the Final Rule’s liquidity fee framework 12 months from the effective date of the Final Rule.
The Commission’s latest attempt at money market fund reform was not received with universal acclaim. While the industry was relieved that a swing pricing requirement was not included in the Final Rule, some question whether the Commission should have sought comment on the mandatory liquidity fee framework that the Commission adopted instead of swing pricing.
Further, as evidenced by the 3-2 vote leading to the adoption of the Final Rule and comments from Commissioners Hester Pierce and Mark Uyeda, there is little agreement on whether the Final Rule will help alleviate redemption pressures on money market funds during times of market stress or exacerbate such pressure, as certain components of the 2014 reforms did.
However, given the aggressive compliance timeline laid out by the Commission, money market funds should begin working toward bringing their portfolios into compliance with the revised minimum liquidity thresholds and implementing the liquidity fee framework imposed by the Final Rule.
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[1] See Money Market Fund Reforms; Form PF Reporting Requirements for Large Liquidity Fund Advisers; Technical Amendments to Form N-CSR and Form N-1A, Rel. No. IC-34959 (July 12, 2023).
[2] See Money Market Fund Reforms, Rel. No. IC-34441 (Dec. 15, 2021).
[3] “Daily liquid assets” include cash, US Treasury securities, certain securities that convert to cash within one business day, or amounts unconditionally due within one business day from pending portfolio security sales; “weekly liquid assets” include cash, US Treasury securities and certain other US government securities, certain securities that convert to cash within five business days, or amounts unconditionally due within five business days from pending portfolio security sales.
[4] Note, however, that the Final Rule only permits a money market fund to reduce the number of its shares outstanding to maintain a stable NAV per share if the fund has negative gross yield as a result of negative interest rates, and therefore may restrict the fund’s ability to use such a mechanism to maintain a stable NAV per share under other circumstances.